Why a bear market is a “good time” for a Roth conversion
If you don’t have niche investments, your portfolio value is low right now. The S&P 500 has fallen nearly 18% over the past 12 months, and the broader bond market hasn’t fared much better, down 13%.
But depending on your tax situation and the types of accounts you maintain, now may be the perfect time to transfer money from a traditional IRA to a Roth account, a move known as a Roth conversion.
Because Roths are funded with pre-tax money, you’ll have to pay a bill for any investments you transfer. But the lower the value of these investments, the less tax you pay.
“Now is a great time to talk about Roth conversions because the market is down,” says Brian Schultz, CPA and tax partner at accounting and wealth management firm Plante Moran. “The lower-than-normal conversion has been too big for some investors who could have benefited from it.”
That’s why financial experts say a Roth conversion can be an interesting move for anyone considering it right now.
Traditional IRAs vs. Roth: “You Can’t Beat the 0% Tax Rate”
To understand the benefits of a Roth conversion, it’s important to know the key differences between traditional and Roth IRAs.
Traditional IRAs are funded with pre-tax money, meaning you can deduct all contributions you make in a given year from your taxable income. But because you’ve waived taxes upfront, you’ll owe them when you withdraw the money in retirement. If you withdraw before age 59.5, you’ll also owe a 10% penalty.
Roths, on the other hand, have no down payment because you fund these accounts with money you already pay taxes on. But once you reach age 59.5, you can take all your money, including investment gains, tax-free, provided you’ve held the account for five years or more. You can withdraw up to the amount you deposited at any time without penalty.
Which account is right for you depends on your individual financial situation, but if you’re looking to pay less in taxes overall in retirement, a Roth is recommended. That’s why many financial professionals recommend Roth IRAs to early-stage investors whose salaries may rise, pushing them into higher tax brackets.
Note that the government can also raise taxes. But because all the income you earn from a retirement Roth is tax-free, these accounts can provide comfort for investors of any age, says Ed Slott, CPA and founder of IRAHelp.com.
“Your money grows for your tax-free income for the rest of your life, making the conversion a good hedge against higher tax rates in retirement,” he said. “You can’t beat the 0% tax rate.”
Why is a bear market a good time for a Roth conversion?
While the reasons above can make a Roth conversion attractive to anyone worried about a higher tax rate in retirement, it can be especially beneficial for younger workers who expect to have more income in retirement. If the government raises tax rates, they will owe more tax on their IRA distributions.
If this sounds like you, then why now is the time to do it.
Since you’re not taxed on your traditional IRA money, you’ll have to pay taxes if you convert to a Roth. But if the value of your portfolio is currently falling, it’s cheaper than ever to move your stocks.
Say you own 10 shares of an ETF worth $100 each in a traditional IRA. If you convert it to a Roth, you’ll pay tax on the dollar value of the stock: $1,000. But if your portfolio was down 20%, you could move those 10 stocks and pay $800 in taxes.
Once your stocks are converted, they’ll ideally continue tax-free in your Roth account until you’re ready to withdraw the money in retirement.
“There’s no doubt that if you’re paying for something and it costs less, that’s good,” says Slott. “But you never know when the market is really going down. Timing the market for a Roth conversion is difficult.”
As Slott points out, the market could rise again or fall even further from current levels, so you never know if you’re getting the best deal possible.
So if you’re interested in converting, he suggests planning a series of small conversions until 2026, when the low tax rates set out in the Tax Cuts and Jobs Act expire. .
“You can do it this year and then again in 2024 and 2025 and then the party is over under current law,” Slott said. There is no limit to the amount you can convert or the number of conversions you can make in a year.
Avoid negative aspects
Like almost everything else about taxes and investments, Roth conversions are complicated moves that are best done under the supervision of a trusted professional.
There are also a few downsides to consider when deciding whether this is a smart move for you.
First, they are permanent. You are no longer allowed to “roll over” your Roth conversion to a traditional IRA. If you convert a portion of your investments, the tax bill is due even if a financial emergency depletes your cash reserves between the time of conversion and tax day.
Depending on the amount of money you’re transferring, making the switch could mean an income stream big enough to push you into higher brackets. This, in turn, may deprive you of certain tax benefits.
And don’t turn over the money you’ll need soon. You can’t withdraw your converted Roth funds or their earnings for five years after you switch, regardless of your age. If you do, you will have to pay tax and a 10% penalty on the amount withdrawn.
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